Bitcoin bust: Virtual currency in flash crash mode

WASHINGTON, April 12, 2013 – Bitcoin, the hot, sort-of-but-not-exactly-new virtual currency seems to be going the way of oil and gold this morning: down. At last check this morning, a bitcoin was worth $60. Not bad, you say? No, not good. Just this past Wednesday, one bitcoin peaked out at $266 per coin before tanking, hitting a low of $120. Thursday, bitcoins endured a “trading halt” on one of its largest exchanges—known at “Mt. Gox”—that lasted for half a day. That didn’t stem the tide, though, as bitcoins have lost nearly 80% of their value in just two trading days. And we thought Apple options were volatile.

As a so-called virtual currency, a bitcoin is made up of digital bits and is allegedly based on cutting-edge mathematical algorithms meant to guard it against counterfeiting. Interestingly, it also appears to have been founded on an old idea, now dismissed by mainstream economists, about how a currency should operate—an idea that could be setting bitcoins up for an abrupt plunge.

Bitcoin was started in 2009 as a currency free from government controls, an entirely digital means of exchange for a digital age. It’s a rapidly growing phenomenon that has taken root as a payment method on some websites for both legal and illegal goods. The entire phenomenon seems to be a weird amalgamation of anarchism—born, in this case, due to an increasing distrust in some quarters of rapidly-debased fiat currencies like the dollar—and “Going Galt,” a process detailed in Ayn Rand’s controversial novel Atlas Shrugged, whereby an entrepreneurial genius goes underground in protest of increasing world socialism, taking the captains of productive capitalism with him in order to evade statist control.

On another level, though, bitcoins are the latest, techiest example of the 1960s’ energizing but ultimately failed hippie culture. In this case, however, it’s tech wienies and their philosophical soul mates who are using, effectively, a conjectural currency to do a John Galt on the system. On the other hand, you could probably argue that Ben Bernanke is doing the same thing via the Fed, although the Fed chair at least has a veneer of legitimacy to back up his efforts.

Yet bitcoins are also different from the “Federal Reserve Notes” we carry in our wallets and purses. They can be extraordinarily volatile for at least two key reasons, both of which we’ve seen this week.

Each bitcoin was typically worth less than $10 for most of the currency’s history. But this week the value surged past $200 – with the recent bailout crisis in Cyprus seen by many as one of the triggers of the surge. Wednesday saw a “flash crash,” as the value dipped close to $100 before recovering. Point one, then, is that this “currency” behaves more like a stock or a commodity than a so-called legitimate currency backed by a recognized government entity.

The meteoric rise and fall in bitcoin value this week is also linked to what some economists say is the biggest problem with the currency: that the supply of bitcoins increases only slowly, at a rate that’s coded into the system, which is our second point.

That’s a contrast to a regular paper currency like the dollar, whose supply is managed by a central bank like the Federal Reserve. The Fed engineers the dollar supply to increase slightly faster than the growth of the economy, which means that the value of the dollar falls slightly every year, in the phenomenon known as inflation.

New bitcoins are “mined” or generated by computers. They get harder to generate all the time, which means the inflow of fresh bitcoins keeps falling. There are about 8 million bitcoins in circulation today, and the maximum that can be generated is 21 million. By 2032, 99 percent of those will have been created.

Since the supply of bitcoins grows so slowly, any increase in demand leads to higher prices. That’s known as deflation, and it’s widely seen as a disaster when it happens to a real-world currency. As money becomes more valuable, our incentive is to hold onto the money instead of spending it – slowing down the economy.

In other words, as we always advise in this column anyway, whether you think bitcoins are the way of the future or still believe in the magic of traditionally valued stocks, bonds, and commodities, travel at your own risk. Tulips and residential real estate were the way to go. For awhile. That may also be the case with bitcoins.

As to the actual stock market this morning, it’s a mixed bag. The bitcoin mess, even though it’s not directly connected to Wall Street trading, added a bit of uncertainty to this morning’s market tone, as did the Fed’s weird, accidental release of information earlier this week, when we learned there’s at least the possibility that some 154 individuals and/or institutions may be receiving and may have been receiving special Fed info in advance of you and moi. We’re, shocked. Shocked.

Add to this some apparent stockpiling (read “hoarding”) of mass quantities of physical copper by speculators, and the latest ravings of North Korean Chief Nutter Kim-whatever, and some slightly-less-than-promising forward-looking comments from banking giant Wells Fargo (WFC), and you get an anemic Friday market opening like today where the Dow quickly plunged a good fifty points before recovering somewhat to the negative teens as about 10:15 a.m. EDT with the other averages performing proportionally the same.

For all the above reasons, we’re returning to the policy we’ve mostly been maintaining throughout the last month or so. If a position is nicely profitable and appears to be topping out, we’ll exit when appropriate, and will likely only accumulate positions in utilities and the occasional REIT or MLP, re-entering the latter two as prices settle down and become slightly better bargains. Anything without some above average yield in this market is an accident waiting to happen. Including bitcoins.

–AP contributed to this report

Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate. He intends to nibble on the preferred stocks mentioned above as the occasion warrants.

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Biographical Note: Dateline Award-winning music and theater critic for The Connection Newspapers and the Reston-Fairfax Times, Terry was the music critic for the Washington Times print edition (1994-2010) and online Communities (2010-2014). Since 2014, he has been the Business and Entertainment Editor for Communities Digital News (CDN).
A former stockbroker and a writer and editor with many interests, he served as editor under contract from the White House Office of Science and Technology Policy (OSTP) and continues to write on science and business topics. He is a graduate of Georgetown University (BA, MA) and the University of South Carolina where he was awarded a Ph.D. in English and American Literature and co-founded one of the earliest Writing Labs in the country. Twitter: @terryp17